15 February 2019

Peg still best bet but endgame closer for HK dollar

Oct. 17 was the 30th birthday of the Hong Kong-US dollar peg. Throughout the years, critics of the peg have charged that it has caused asset bubbles, wealth inequality, inflation and economic volatility. The critics also say that Hong Kong’s transformation to a service-based economy has made the peg redundant.

But no one seems to realise that the endgame for the HK dollar is already in sight. It will vanish when the renminbi becomes fully convertible. This endgame, however, is some years away. Between now and then, the peg still seems to be Hong Kong’s best option for maintaining systemic stability.

Scrapping the HK dollar peg would not necessarily solve the problems – the high inflation and economic volatility, the income inequality and asset bubbles – that it is accused of causing. That is because the HK dollar peg aggravates but not generates these problems.

Hong Kong experiences inflation as well as deflation and disinflation through the cycles, which are driven by external demand factors but not the peg. Its property bubble has been caused by a chronic housing supply shortage, which has nothing to do with the exchange rate system. Income inequality here has been a result of globalisation and Hong Kong’s economic restructuring. With or without the peg, it is going to happen. There is also evidence that Hong Kong’s economic volatility, as approximated by the standard deviation of GDP growth, is not much different from neighbours that don’t have currency pegs.

Finally, Hong Kong derives income from services exports and investment abroad amounting to almost 90 percent of GDP. The HK dollar peg serves to protect this big portion of foreign income from excessive volatility due to large swings in the exchange rate. Being a service-based economy does not render the peg irrelevant.

I can provide more counterarguments than criticisms of the HK dollar peg. But let’s assume we want to scrap the peg. What alternatives do we have?

First and foremost, free floating is a non-starter because it would lead to a sharp rise in the HK dollar exchange rate due to Hong Kong’s balance of payments surplus. That would surely hurt Hong Kong’s trade-dependent economy.

Re-pegging the HK dollar to the renminbi makes no sense until the renminbi becomes a fully convertible hard currency, as Hong Kong is still functionally more integrated with the US dollar areas, both in capital markets and international trade. The lack of well-developed renminbi derivatives means that there are no hedging tools for renminbi foreign exchange risk. Pegging to the renminbi will also require Hong Kong to be governed by China’s monetary policy, clear implausible given Hong Kong’s free market and the lack of market discipline in China’s monetary policy.

Further, Hong Kong cannot use a non-convertible currency to back up its monetary base, which is fully convertible to the US dollar. Linking the HK dollar to the offshore renminbi is also implausible because under the currency board arrangement of the peg, China’s central bank is required to fully back the HK dollar’s monetary base using offshore renminbi in response to capital flows. This would amount to making the renminbi indirectly fully convertible through Hong Kong, which is not in Beijing’s game plan.

Re-pegging the HK dollar to the US dollar at a different level would only hurt the credibility of the peg and invite recurring speculative attacks by creating a one-way bet for currency speculators. Local interest rates would then become more volatile and more distortive to the investment environment.

Similarly, re-pegging the HK dollar to the euro or a basket of currencies would induce the same credibility problem as re-pegging it at a different US dollar level. It is also impractical. Pegging to the euro would mean Hong Kong importing the European Central Bank’s monetary policy. But the ECB’s inflexible policy stance is unlikely to suit Hong Kong’s small open economy, which needs flexible policy responses to economic shocks. Relative to the ECB, the US Fed has a more flexible policy stance.

If the HK dollar were to be pegged to a basket of currencies and retain its hard-currency status with high liquidity, it could only be pegged against fully convertible currencies. The potential candidates for inclusion in the basket would be the US dollar, the euro, the Japanese yen, the British pound, the Canadian dollar, the Singaporean dollar, the Australian dollar, the New Zealand dollar, the Swiss franc, the Norwegian krone and the Swedish krona. But the inclusion of small currencies that are not used for global invoicing and have only weak trading links with Hong Kong makes little sense. That leaves the US dollar, the euro and the Japanese yen as realistic candidates. With the US dollar still a dominant currency in Hong Kong’s economic life, pegging the HK dollar to such a narrow currency basket would make little difference to pegging it against the US dollar.

Hong Kong’s small open economy is affected by many international forces, so it has a high growth-volatility tendency. Monetary autonomy can do little to counteract the large economic shocks inflicted by international crosscurrents. Anchoring its exchange rate to the currency of a large, flexible and relatively creditworthy economy remains a practical means of preserving confidence and reducing foreign exchange risk caused by external forces.

Let’s face it. The endgame for the HK dollar is already in sight. When the renminbi becomes fully convertible and backed by credible economic and policy fundamentals, the HK dollar will cease to exist. But this is some years away. In the absence of a better alternative to the HK-US dollar peg, changing the status quo will only create chaos and not solutions. The peg should stay until its eventual retirement.

Chi Lo, senior strategist, BNP Paribas Investment Partners (Asia) Ltd, and author of “The Renminbi Rises: Myths, Hypes & Realities of RMB Internationalisation and Reforms in the Post-Crisis World”, Palgrave Macmillan 2013



Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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